Chinese bank valuations imply a bad loan ratio of 13 per cent
That's about the same figure the lenders had in 2003 before they were restructured, and a far cry from the 0.97 per cent that the banks claim
Yesterday the South China Morning Post reported that the price of mainland-listed bank shares had fallen below the book value of their net assets per share.
It wasn't just the mainland-listed shares. On Monday, the weighted average price-book value ratio for the 10 Chinese banks listed in Hong Kong fell to just 0.98. In other words, as an investor you would have been able to buy shares in Chinese banks for less than the cash you would have received - in theory - if the companies were wound up the following day and the residual value returned to shareholders.
That's a highly unusual state of affairs, especially in a rapidly developing economy like China's where banks have traditionally been regarded as a geared play on future growth.
In contrast, among Hong Kong's local banks, Bank of China (Hong Kong) is currently trading on a price-book ratio of 1.7, while Hang Seng Bank is on a robust valuation of 2.3. For Chinese bank shares listed in Hong Kong, the long-term average is 1.75.
Some observers argue that the current abnormally low valuation of China's banks is an aberration which represents a great buying opportunity.
There is, however, another interpretation.
Imagine that the market has got the pricing of Chinese bank shares about right. That would imply the value at which they are carrying assets on their books is far too high.
Or, to put it another way, the proportion of non-performing loans on the balance sheets of China's commercial banks is a lot greater than they are admitting. A very rough back of an envelope calculation suggests how high the true level of bad loans might be.
If the long-term price-book ratio were an accurate representation, it would imply the real value of bank net assets should be some 40 per cent below their declared level.
In turn that would imply bad loan losses of about 3.6 trillion yuan (HK$4.6 trillion) on top of the 1.6 trillion yuan China's commercial banks have set aside. That would suggest total potential loan losses of 5.2 trillion yuan.
Let's assume China's banks would be able to realise 30 fen on the yuan for their bad loans, which is about what was recovered on Southeast Asia's non-performing loans after the currency crisis of the 1990s. That would leave us with bad loans worth a total of 7.4 trillion yuan, or 13 times the 564 billion yuan in non-performing loans that China's banks acknowledged at the end of September.
So, the dismal price-book valuation investors are currently putting on Chinese bank shares suggests they believe the true proportion of the banks' loan books that should be classed as non-performing is not the 0.97 per cent the banks claim, but very nearly 13 per cent.
That's roughly the same bad loan ratio that China's banks were on back in 2003, before their last round of restructuring to prepare them for flotation.
This of course is nothing but a rough illustration. But it does illustrate just how apprehensive investors feel right now about buying into China's banking sector.
The gyrations in the mainland's money markets over recent days hint at how the People's Bank of China intends to manage short-term interest rates once it finally gets the go-ahead to liberalise the market.
Forces of supply and demand, along with the central bank's open market operations, will play a large role in setting short-term rates on a daily basis.
But it looks as if the PBOC will seek to dampen volatility by setting an informal band within which key rates like the seven-day repo rate will be confined.
The floor will be the rate the central bank pays on excess reserves; currently 0.72 per cent. The ceiling will be the rate at which it lends to cash-strapped banks from its new Standing Lending Facility.
The PBOC doesn't disclose this interest rate. But considering that the two recent liquidity squeezes saw interbank rates climb no higher than 10 per cent strongly suggests that's the interest at which the central bank was prepared to lend up until Monday.
According to reports, however, yesterday the PBOC was lending through the Standing Lending Facility at just 7 per cent, which implies the central bank is determined to keep the lid firmly on short-term interest rates, at least for the time being.